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The voluntary carbon market has been the breeding ground for offset project types welcomed into California’s regulated carbon market, which many say will face a shortage of offsets in its second phase. Market participants, including an official at one of the largest publicly-owned utilities in the United States, say it is critical for California regulators to quickly welcome even more voluntary project types.

14 April 2014 | Offering its residential customers a chance to minimize the impact of their lifestyles and electricity usage on the environment has been the focus of the Sacramento Municipal Utility DistrictÃ¢â‚¬â„¢s (SMUD) Carbon Offset Program since it launched in 2007. Now SMUD, the public utility for Sacramento County and parts of nearby Placer County in California, is diving deeper into the carbon markets by helping to pay for the development of a new carbon offset project type that focuses on the restoration of wetlands in the state. SMUD is taking this step because the cap-and-trade program that it is regulated by enters its second phase in 2015, and many experts say its narrow palette of recognized offsets wonÃ¢â‚¬â„¢t meet projected demand starting in 2015 through the life of the program.

SMUD Ã¢â‚¬â€œ one of the 10 largest publicly-owned utilities in the United States Ã¢â‚¬â€œ allows its customers to lower their contributions to climate change with a $10 per month added charge on their bills. The charge has financed the purchase of carbon offsets from projects registered under the Climate Action Reserve (CAR), Ã¢â‚¬â€œ an offset registry that supports projects to reduce greenhouse gas (GHG) emissions Ã¢â‚¬â€œ including offsets generated by a dairy digester.

The utility joined forces last year with the American Carbon Registry (ACR), a different offset registry organization, and other partners on the development of a new method (or protocol) that would count the GHG emissions reductions created from projects that restore California deltaic and coastal wetlands and turn those into offsets for both the voluntary and eventually, they hope, for CaliforniaÃ¢â‚¬â„¢s regulated carbon market.

SMUD set out to identify voluntary offset protocols that are good candidates for acceptance by the California Air Resources Board (ARB), Ã¢â‚¬â€œ the regulatory agency overseeing the stateÃ¢â‚¬â„¢s carbon market Ã¢â‚¬â€œ that have potential to deliver GHG emissions reductions within California and that also deliver co-benefits Ã¢â‚¬â€œ social, economic and environmental benefits beyond carbon reductions. The utility started out with a list of 12 project types and narrowed the list down to six after research and discussions with stakeholders, Obadiah Bartholomy, SMUDÃ¢â‚¬â„¢s Senior Project Manager, told attendees at the Navigating the American Carbon World conference in San Francisco last month.

The list of offset project types that could be added to the stateÃ¢â‚¬â„¢s roster Ã¢â‚¬â€œ which currently includes forestry, urban forestry, livestock and ozone-depleting substances protocols originally developed in the voluntary market Ã¢â‚¬â€œ and would benefit from a demonstration project or further development includes avoided conversion of grasslands, nutrient management, rangelands soil carbon sequestration and enteric fermentation, he said. Rice cultivation, which the ARB could approve in September, was also on the list.

However, the protocol that caught SMUDÃ¢â‚¬â„¢s attention was wetlands restoration, with the partners tailoring an ACR protocol already developed for the Mississippi Delta to suit California. The California version is still under development and has a long ways to go before producing offsets for the stateÃ¢â‚¬â„¢s regulated market, likely not until 2018, assuming California regulators adopt the protocol, he said. But the protocol has the potential to produce a significant amount of offsets Ã¢â‚¬â€œ anywhere from seven to 26 million tonnes of avoided carbon emissions, according to ACR estimates Ã¢â‚¬â€œ and has the attractive co-benefits that SMUD is actively looking to support.

Ã¢â‚¬Å“The others, other than rice, seemed a little farther out with even more barriers to expanding supply, not to say that we shouldnÃ¢â‚¬â„¢t pursue them,Ã¢â‚¬Â Bartholomy said. Ã¢â‚¬Å“We have to keep in mind that this is a very long-term endeavor that weÃ¢â‚¬â„¢re embarking on.Ã¢â‚¬Â

WhatÃ¢â‚¬â„¢s the Rush?

To date, the ARB has issued more than 7.5 million offsets, which should be plenty for the first phase of the program given that some organizations, particularly smaller entities, regulated by the cap-and-trade program have been slow to embrace offsets, market experts said.

SMUD, which is regulated by the cap-and-trade program because of its natural gas facilities and power imports, is one of the entities that have so far hesitated to make use of offsets to fulfill its compliance obligations, Bartholomy admitted.

Ã¢â‚¬Å“SMUD is one of those thatÃ¢â‚¬â„¢s kind of on the bubble,Ã¢â‚¬Â he said. Ã¢â‚¬Å“I think we are going to make use of our 8%, but it takes some internal education and discussion and some willingness for us to bite the bullet.Ã¢â‚¬Â

What the experts are concerned about is what they say is the likelihood that there will be a shortage of offsets in the middle and latter years of the program. California entities are allowed to meet up to 8% of their compliance obligations using offsets, meaning that the maximum demand during the second phase of the program in 2015-2017 is 91.8 million offsets. While many experts say the 8% maximum will never be exhausted, they are concerned that there will simply not be enough offsets generated under the four project types currently allowed in the program.

Ã¢â‚¬Å“My view is that the offset supply will be extremely short,Ã¢â‚¬Â said Derek Six, CEO/CFO of offset project developer Environmental Credit Corp. Ã¢â‚¬Å“I think weÃ¢â‚¬â„¢ll be short for a very long time.Ã¢â‚¬Â

Consultancy Alpha Inception projects that total demand for offsets will only be about 50% of the possible maximum demand, meaning that the market should come out of the first compliance period with a pretty big surplus, but could be short in the second and third phases depending on what else happens in the market, said Founder and Manager Director Andre Templeman.

Another concern is that it takes time Ã¢â‚¬â€œ usually several years Ã¢â‚¬â€œ to get through the ARBÃ¢â‚¬â„¢s rigorous evaluation process, the experts noted. In fact, the rice cultivation protocol, as well as one for coal mine methane projects, have been delayed several times as top regulators have sent their staff back to the drawing board for further examination and development.

Ã¢â‚¬Å“They are being extremely conservative and with good reason,Ã¢â‚¬Â Templeman said. Ã¢â‚¬Å“They donÃ¢â‚¬â„¢t want any holes to be opened up, especially in these early years of the program.Ã¢â‚¬Â

CaliforniaÃ¢â‚¬â„¢s cap-and-trade program is currently scheduled to end in 2020, but there are discussions about how to meet the stateÃ¢â‚¬â„¢s 2030 target for reducing GHG emissions, with continuing the program Ã¢â‚¬â€œincluding the offsets component Ã¢â‚¬â€ being an option on the table.

Ã¢â‚¬Å“In those types of timeframes, expansion of supply through additional protocols is quite viable,Ã¢â‚¬Â Bartholomy said.

WhatÃ¢â‚¬â„¢s the Problem?

CaliforniaÃ¢â‚¬â„¢s offset market has been plagued by a host of regulatory and legislative disruptions that have had the effect of restraining the development of offset projects, Templeman said. For example, a bill introduced into the California legislature last year by Senator Ricardo Lara sought to exclude all offsets outside of the state. The bill, which is likely to resurface this year, eventually was amended to focus its restrictions on international offsets because of arguments that CaliforniaÃ¢â‚¬â„¢s stringent environmental regulations would severely limit in-state offset development, he said.

Ã¢â‚¬Å“ThatÃ¢â‚¬â„¢s the reality,Ã¢â‚¬Â Templeman said. Ã¢â‚¬Å“If you took all of the out-of-state offsets out, you wouldnÃ¢â‚¬â„¢t leave very many behind. That would be an interesting bill were it to pass because I think that would affect supply quite dramatically and in essence create a massive shortage.Ã¢â‚¬Â

Ã¢â‚¬Å“That pressure is not going to go away,Ã¢â‚¬Â he added. Ã¢â‚¬Å“There will be a bill at some point that will basically seek to say Ã¢â‚¬ËœweÃ¢â‚¬â„¢re paying for it, we want some of the benefits to be localÃ¢â‚¬â„¢.Ã¢â‚¬Â

Another proposal not specific to the offset program would exempt the transportation sector that is scheduled to be phased into the cap-and-trade program in 2015 from its grasp by instead implementing a carbon tax on fuels. While the odds of the proposal making it into law are not strong, that bill if adopted would have a dramatic impact on the offset market because removing the transportation sector would have the effect of turning a market that is projected to be short into one that could be oversupplied by a factor of two, Templeman said. The mere proposal is problematic because Ã¢â‚¬Å“even if the bills themselves die, there are reasons these bills come up,Ã¢â‚¬Â he said.

And then, of course, there are the so-called buyersÃ¢â‚¬â„¢ liability provisions of CaliforniaÃ¢â‚¬â„¢s cap-and-trade program, which allows the ARB to invalidate offsets that the agency deems problematic and forces the buyers of these offsets to take responsibility for replacing them. The risk adds to the cost of buying offsets and makes them a less attractive option for smaller entities, Templeman said.

Ã¢â‚¬Å“You really have to be over a certain size before it really makes a lot of sense in todayÃ¢â‚¬â„¢s current market design,Ã¢â‚¬Â he said, adding that he expects products to emerge during the second and third compliance periods that will address the invalidation risk for a cost.

Other concerns that have kept smaller entities out of the market, including the potential of getting stuck with offsets they did not need to purchase, should subside after the first few years of the program, Bartholomy said.

Ã¢â‚¬Å“I think that fear will recede as the market continues to demonstrate success,Ã¢â‚¬Â he said.

WhatÃ¢â‚¬â„¢s the Solution?

Aside from adopting protocols from SMUDÃ¢â‚¬â„¢s list of potential candidates, the ARB could also amend their rules to maximize the supply generated from the protocols already eligible. The costs of verifying the emissions reductions generated by livestock projects, for example, under current ARB rules are so high that they essentially exclude more than 95% of the dairies in the United States from participating in the program, Six said.

And the ARB could revisit voluntary offset protocols that it has previously rejected, such as pneumatic valves in the oil and gas sector, nitric acid production and organic waste digestion, in part because of the view that some of these activities are already regulated even if the specific emissions reductions associated with them do not fall under the carbon cap, Bartholomy said.

Ã¢â‚¬Å“Unfortunately, the logic behind that is still kind of murky,Ã¢â‚¬Â he said. Ã¢â‚¬Å“I think we can hold out some hope that maybe if there is a shortage they may be willing to expand the offset supply.Ã¢â‚¬Â